For a while now, two discussions have captured my attention. The first is about a ”startup bubble” and its eventuality to burst, and the second is the threat of rising interest rates and its influence on private equity. Why do my ears perk up when I overhear these conversations or find myself clicking link after link on articles relating to either topic? Because I feel that they are quite closely related to the same issue. Venture capital firms invest in startups due to their high return rate and need for cash flow. But where does that money come from? Private equity. And if interest rates on rise, there could be a movement of capital back to more traditional paths, all leading to a pullback of venture funding and a need for startups to think differently. This is the worry I’ve been hearing.
I’m not an economist by any means – in fact, I’d even go out on a limb to say that 80% of people know more than I do. But I do appreciate the history of US economics, as you should, too. That being said, please note that this commentary is my opinion based on the knowledge I have at this time. After examining “the housing bubble” and the Greenspan years (as we’re essentially still exercising those Federal Reserve strategies on today’s Monitory Policy) there are some alarming overlaps between the current economic state of startups and the housing bubble collapse in 2008.
Kick out the bad
I don’t believe that there is a startup bubble — those of us in tech and startups aren’t as big of stakeholders in the grand scheme of a potential economic pullback as we’d like to think. Government debt is a much larger player. The world of tech funding, while very large, at comparison is still nominal. And without enough vertical force, we’re not going to feel a big down swing. Additionally a few startups have created products that are wanted globally, which is exactly what we need in order to stabilize our current state of industry. But what if we don’t do that? Well if/when this “bubble” bursts, you won’t see huge Great Depression era economic turmoil but there will be difficulty for those businesses that relied far too heavily on the accessibility of this equity.
The real juice
If there’s anything to worry about, it’s this: Right now everyone in tech startups are receiving capital investment — there’s a very low barrier to entry on concept ideas and truly weak diligence being done on the businesses. And much like our lesson in 2008 with the housing bubble (the overlap I see), handing out debt like it’s free and exchanging debt for cheaper debt isn’t sustainable at all. Don’t believe me? Let’s say your venture capital seed round of 500k was an institutional loan. A majority of startups (and I personally have seen the accounting for many of them) would incur an immediate margin call, meaning the business doesn’t have enough revenue to support the costs to run itself and the trajectory of the debt over time. This is hazardous because it causes the need for even more debt to find any opportunity to get out of it. And once more, a business practicing that behavior is not one to be recognized as a stable investment and/or desired in global economics. In the housing bubble, some consumers had as many as 2-3 mortgages, each one trying to pay the other off until it just couldn’t hold anymore. Thus a bag of shit was left being held by those who fell into the trap when the money train stopped. Or in our worst-case scenario, you the entrepreneur could be leaving your team jobless because you couldn’t sustain your business.
So what is a key factor in this type of poor environment? False consolidation. Unfortunately and fortunately its equivalent in the startup space are acquisitions. These acquisitions happen because the business can’t support itself anymore; so in order to keep moving forward, it must consolidate its “debt” under a higher ceiling. Hence why companies with large amounts of capital are the ones making these acquisitions (higher ceiling). Not exactly ideal. On the brighter side, big transactions where a company is brought onboard to amplify resources under a larger umbrella, does occur. But it’s not your everyday scenario and definitely not the one you’re reading about on the tech blogs each day.
Bottom line, you are here to make money
I get it, you want to make invention. And please, do that! But you must understand that the only true way to measure the steed of your invention is against economics. I would prefer that entrepreneurs walk away from meetings with angels and VC’s who are turned off by the fact that your business either already makes money (Quiz: if it doesn’t make any money, who should really be the one getting the reality check?) or that you have a strategy to make it happen.
Develop a strategy, put the economics into a spreadsheet and clearly define your approach to support the true cost of operations before incurring any capital. This will put you in a more desirable position to access capital when you’re ready for it, ultimately make your business better and save us all from heading in the most blind direction possible.